Second mortgages can be an excellent strategy for homeowners to leverage the equity in their property, thereby freeing up cash for critical needs.1 As with any financial product, understanding the fundamental components of second mortgages is essential before embarking on the application journey.
What Constitutes a Second Mortgage?
Fundamentally, a second mortgage enables you to borrow against the accumulated equity in your home, with your property serving as collateral for the loan.2 This loan is termed a “second mortgage” because its lien position is subordinate, or second, to the existing loan already secured by your property. Second mortgages can often be simpler to qualify for than other loan types and are frequently utilized to secure additional funds.
According to Scott Bridges, Senior Managing Director of Consumer Direct Lending at Pennymac, “Second mortgages can give you access to the equity in your home without having to touch your first mortgage. Depending on your financial needs, second mortgages can be provided in lump sums or similar to a credit line where you can spend and repay over time.”3
What Are the Potential Uses for a Second Mortgage?
The applications for a second mortgage are diverse. Bridges notes, “We see many of our customers pursue a second mortgage to consolidate high interest rate credit card debt or do home improvements.” Some of the most common uses for a second mortgage include:
- Financing Home Improvements: A second mortgage presents an opportunity to reinvest in your property.4 Undertaking significant home improvements is generally considered the most prudent reason to acquire such a loan, as the home’s value should appreciate, reflecting your financial investment.
- Funding Education: The equity in your home can provide a substantial loan to finance educational pursuits for yourself or your children.5
- Covering Healthcare Costs: Unforeseen healthcare expenses can impose considerable financial strain. A second mortgage may offer a lower-interest loan option compared to other available credit facilities.6
- Debt Consolidation: A second mortgage can be an effective strategy for paying off balances from multiple high-interest credit cards.7 This allows you to streamline your payments by eliminating numerous credit card bills, and you will typically save money as long as your second mortgage interest rate is lower than your credit card rates—which is usually the case.8
How Does a Second Mortgage Work?
A second mortgage involves securing an additional loan against a property that is already subject to an existing mortgage.9
Types of Second Mortgages
A home equity loan and a home equity line of credit (HELOC) are the two loan types that fall under the broad, informal umbrella category of “second mortgage.”10 Both of these instruments use your home as collateral, but they possess distinct nuances. Let’s examine each one.
- Home Equity Loan: A home equity loan is a traditional installment loan, meaning a fixed amount is disbursed to you for a fixed term, with payments amortized, or spread out, over the life of the loan.11 You receive the entire sum of money in a lump sum upon loan closing. Home equity loans typically come with fixed interest rates.12
- Home Equity Line of Credit (HELOC): A Home Equity Line of Credit (HELOC) provides you with the flexibility to draw money as needed, up to the maximum amount of your credit line, for a defined period known as the draw period.13 During this draw period, payments are generally interest-only. Once the draw period concludes, your payments shift to cover both principal and interest, which are then amortized over the remaining loan term. Home equity lines of credit usually feature a variable interest rate.14
How Do I Access the Funds?
You can receive your funds in two distinct ways, depending on whether you have a home equity loan or a HELOC.
- Lump Sum: A home equity loan is a standard second mortgage, representing a one-time loan that provides a lump sum of money you can utilize for any purpose you desire.15 With this type of loan, you repay the loan over time, typically through fixed monthly payments.16 Each payment incorporates a portion of the interest, as well as a portion of your outstanding loan balance.17
- Credit Line: With a HELOC, you can receive an initial lump sum if required, and also have a pool of funds from which you can draw over time. While you may be obligated to take an initial draw (a lump sum paid out when the line is opened), you also have the option to access additional funds later. Your lender establishes a maximum borrowing limit, and you can continue borrowing multiple times until you reach that credit limit. Similar to a credit card, as long as you haven’t maximized your line, you can repeatedly borrow on a HELOC.
Is a Second Mortgage Different from Refinancing?
Yes, a second mortgage is distinct from refinancing.18 A second mortgage is an additional loan secured by your home, where you borrow against your home’s equity.19 With a second mortgage, you will be responsible for two separate home loan payments—your original mortgage and the second mortgage.20
Refinancing, conversely, replaces your current primary mortgage with an entirely new one.21 Homeowners frequently refinance their homes to capitalize on a lower interest rate, alter a loan term, or switch from an adjustable-rate to a fixed-rate mortgage.22 Some individuals choose to undertake a cash-out refinance, which involves refinancing a home loan for an amount exceeding the existing loan balance.23 The extra funds can then be used for renovations, debt consolidation, education, or other expenses.24
How Do I Obtain a Second Mortgage?
To acquire a second mortgage, you will need to apply for the loan and satisfy the lender’s requirements, which may be more stringent than those for your original loan.25 Lenders will need to be confident in your ability to manage an additional monthly loan payment.
Approval criteria will vary by lender, but as a minimum, you will need sufficient available home equity, a high credit score, and a low debt-to-income ratio (DTI).26
Second Mortgage Rates: Securing the Most Competitive Rates
Second mortgage rates and terms differ among lenders. Compare your options to identify the one that best aligns with your budget and financial objectives.
Keep in mind that, similar to your original mortgage, certain factors such as credit history and existing debt will play a role in determining your rates.27 You will also need to possess a certain amount of equity. Bridges states, “The way to get the best rate on a second mortgage is simply to have a strong credit score, a low debt-to-income ratio and equity in the home after the second mortgage is acquired.”
Is a Second Mortgage the Right Choice for You?
While a second mortgage offers numerous benefits, it undeniably entails incurring additional debt.28 You will need to carefully weigh the pros and cons to determine if it represents your best financial decision. In many situations, it could indeed be the optimal choice.
Scott Bridges explains, “From a financial planning standpoint, a second mortgage is a good idea when the homeowner has a significantly lower rate on their first mortgage than the current market. Imagine you have a 3% first mortgage and need $100,000 to consolidate debt or do home improvements. Right now it’s typically smarter for homeowners to utilize the second mortgage to tap into their equity instead of refinancing their entire loan balance to today’s 6 to 7% rate range.”
Exploring Your Options for a Second Mortgage
The fundamental takeaway is that while second mortgages are common and convenient, it’s crucial to assess if they are a suitable fit for your individual circumstances. If you are prepared to apply, begin by contacting a Pennymac Loan Expert to gain further insight into the second mortgage options available to you.